Tax-free bonds may boost taxes

Published 4:00 am, Sunday, April 1, 2007

Americans were always supposed to report tax-exempt interest from municipal bonds and bond funds on their tax returns, but 2006 was the first year financial institutions were required to report it to customers -- and the Internal Revenue Service -- on Form 1099-INT.

The new reporting requirement is focusing attention on the fact that tax-exempt interest, when entered correctly on a tax return, can sometimes increase your taxes. For example:

-- Tax-exempt interest can increase the tax some lower-income seniors pay on their Social Security benefits.

-- Interest on certain types of municipal bonds known as private activity bonds are subject to the alternative minimum tax, which is hitting a growing number of higher-income people.

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-- Regardless of income, tax-exempt interest is usually subject to state income taxes if it's from an out-of-state bond.

-- Tax-exempt interest could make a lower-income worker ineligible for the earned-income tax credit. To claim this credit, you cannot have more than $2,800 in investment income, including tax-exempt interest. However, most people eligible for this credit don't have much, if any, tax-exempt interest.

In years past, people had to dig through mail from their brokerage firms or mutual fund companies to find their tax-exempt interest and -- if they were subject to AMT -- the portion that came from private activity bonds.

If they didn't report it on their tax return, the only way the IRS would know about it was "if they had had a knock-down drag-out audit and (the IRS) stumbled across it in a brokerage statement," says Frank Lloyd, an enrolled agent in Los Altos.

Lloyd says he has always tried to make sure his clients reported their tax-exempt interest, but he suspects that many people did not, out of ignorance or carelessness. Congress apparently agreed, which is why it instituted the reporting requirement.

Tax-exempt interest can now be found on Form 1099-INT in box 8.

Some taxpayers reporting tax-exempt interest for the first time this year have had a rude awakening. Lloyd has one such client, a woman receiving Social Security benefits.

Social Security impact: To determine how much of your Social Security benefits are taxable, you generally have to add to your adjusted gross income one-half of your Social Security benefits plus all tax-exempt interest.

If this number is bigger than $25,000 (single) or $32,000 (married filing jointly), up to 50 percent of Social Security benefits are taxable.

If this number is more than $34,000 (single) or $44,000 (joint returns), as much as 85 percent of Social Security income is taxable.

In 2005, Lloyd's client reported no tax-exempt interest and owed tax on about $1,395 or 9 percent of her Social Security income.

In 2006, however, she had about $6,600 in tax-exempt income and owed tax on $10,000 or 62 percent of her Social Security income.

The final difference in her tax bill because of the tax-free interest reporting was $643.

Needless to say, she was pretty surprised. "Now I have to talk to her about prior years," Lloyd says. She could need to file amended tax returns if she had tax-exempt interest in previous years.

Lloyd points out that that if you already owe tax on 85 percent of your Social Security benefits, the addition of tax-exempt interest will have no impact on you.

It's lower-income seniors -- those below the 85 percent threshold -- who are most affected.

People in this category are likely to be in a tax bracket where they are better off in taxable than tax-free bonds or funds -- irrespective of the Social Security impact.

AMT impact: At the other end of the spectrum, high-income taxpayers subject to AMT are finding that tax-free bonds and funds are not always tax free, Lloyd points out.

Interest from municipal private activity bonds are subject to AMT at either the 26 or 28 percent rate. These bonds finance projects with a public/private purpose, such as airports, stadiums, housing projects and some hospitals.

Interest from private activity bonds can now be found on Form 1099-INT in Box 9.

The AMT is an alternative tax system designed to prevent high-income people from avoiding federal taxes by taking big deductions, including deductions for state taxes. Because it has never been indexed for inflation, more people are falling into it every year, especially high-tax states such as California and New York.

In response, many fund groups have reduced or eliminated their exposure to private activity bonds.

The average municipal bond fund has about 10 percent of its assets in bonds subject to AMT, according to Lipper.

Tax-free money market funds, however, have higher exposure to AMT securities -- 30.6 percent on average and 20 percent for those that invest only in California.

One way to gauge a fund's exposure to AMT is its name.

Funds with "tax-free" in their names generally have up to 20 percent of their assets in private activity bonds.

Funds with "municipal" in their names can have up to 100 percent of their assets in AMT bonds, although most have less than half.

In February, Vanguard Group said that all of its muni funds had eliminated AMT bonds except its money market funds and its high-yield municipal fund.

Fidelity has taken a different approach: It has created funds with and without AMT exposure.

Some funds prefer keeping AMT bonds because in general, they tend to yield a little more.

The highest-yielding retail money market fund, according to Imoneynet, is the Alpine Municipal Money Market Fund. This fund reports that nearly two-thirds of its income is "attributable to securities subject to the AMT."

The Fidelity California Municipal Money Market fund, which has 41.6 percent of its assets in bonds subject to AMT, is yielding only 3.18 percent.

The reason: The AMT-free fund has a higher minimum investment ($25,000 versus $5,000) and lower annual fees than the fund with AMT exposure.

Investors should remember that while municipal bond interest is generally exempt from federal income taxes (except for the AMT exception), many states will tax interest from bonds issued outside of their own states.

Investors can generally avoid this state tax by investing in bonds issued in their home state, or in funds that only buy in-state bonds.